Written evidence from the Trade Union Congress (TUC) LDI0048

The Trades Union Congress (TUC) exists to make the working world a better place for everyone. We bring together around 5.5 million working people who make up our 48 member unions. We support unions to grow and thrive, and we stand up for everyone who works for a living.

The impact on DB schemes of the rise in gilt yields in late September and early October

It is too early to say how large the long-term impact will be of the sharp rise in gilt yields, and the crisis in the liability driven investment sector.

It is clear that on aggregate scheme funding levels have improved as a result of rising gilt yields over the last 12 months as a whole. Rising yields have resulted in higher discount rates and falling liability values on most measures. For example, funding levels on the Pension Protection Fund 7800 index, which measures schemes’ ability to pay out PPF-level benefits, increased from 104.6 per cent to 133.6 per cent between November 2021 and October 2022. Over this period, the Mercer funding index, which tracks deficits at FTSE350 companies on an accounting basis rose from 89.2 per cent to 104.8 per cent and First Actuarial’s FABI Index, which tracks the funding level of all schemes on a best estimate basis, went from 121.7 per cent to 125.0 per cent.  Gilt yields have returned to close to their level before the mini-budget, and if they continue on their trajectory over the last 12 months can be expected to continue to improve funding levels.

But while on aggregate schemes have benefited from rising interest rates over the year, the malfunctioning LDI market will undoubtedly have destroyed value for schemes that employed leveraged LDI strategies. These strategies are employed by schemes that cannot meet the generally prohibitive cost of matching assets by investing in a portfolio of appropriate bonds and so keep some exposure to other higher returning assets while borrowing against the gilts in their LDI portfolio to increase their exposure to gilts.

Those schemes that became forced sellers of illiquid assets to meet large LDI collateral calls caused by the combination of leveraged LDI and rapidly rising gilt yields will have seen asset values reduced as a result. According to Goldman Sachs Asset Management – which targeted these assets as pension funds had to unload – private equity portfolios were trading at a 20-30 per cent discount.  Forced sales have also fundamentally altered the asset allocations of some schemes in ways that may have hampered returns or increased risk.

Schemes that were unable to maintain geared LDI strategies and were forced to reduce hedging at the peak of gilt yields will also have taken a real hit to their funding level. These schemes will have had a lower level of hedging as gilt rates fell after the initial surge – the exact point at which LDI strategies are intended to pay out to hedge against rising liabilities.

We will have to wait to see the scale of the impact, but DB schemes will have a lower aggregate funding level as a result of the malfunctioning LDI market and the rapid rise and fall in gilt yields. The impact will be unevenly felt, with schemes using more highly leveraged LDI strategies the hardest hit. Any assessment of the impact will have to take into account the condition of individual schemes as well as on aggregate.

The impact on pension savers, whether in DB or defined contribution pension arrangements

There should be minimal impact on most DB scheme members, the value of whose pension rests on the strength of their employer covenant. But there may be cases where the strength of this covenant has deteriorated as a result of extra funding requirements or the need to provide emergency liquidity to their schemes to meet LDI collateral calls. This episode may have also reduced the appetite of employers with open DB schemes to continue providing DB benefits. Although these schemes will have had lower LDI allocations than more mature schemes, they will generally have had some exposure.

Individual DC savers may have seen some impact, particularly those approaching retirement who were ‘life-styled’ into bond-heavy allocations before retirement. Those who used their DC pots to buy an annuity should have been compensated for the loss of value to their investments by rising annuity rates linked to rising yields. The fact that yields appear to have reverted to their pre-mini-budget path also means that the long-term impact on DC pot values should be limited. However, those who wished to draw cash on retirement and whose retirement fell just at the ‘wrong’ point in term of bond yields and therefore the value of their fund, may have experienced damage to their retirement plans.

Perhaps the greatest damage caused by this episode is a loss of confidence in the pension system. The widespread reporting of the LDI crisis as a threat to pension fund solvency, rather than a liquidity problem, caused unnecessary alarm for many members. This reporting not only gave a misleading impression of the threat to members’ pensions, it also generally neglected to mention the security provided by the Pension Protection Fund. If this loss of confidence leads DB members to stop contributing to an open scheme or transfer out of a closed scheme it will likely leave them worse off in retirement.

A wider loss of confidence in the pension system, and the large fluctuations of value in supposedly de-risked life-styled DC pots, could also discourage DC members from contributing.

Given its responsibility for regulating workplace pensions, whether the Pensions Regulator has taken the right approach to regulating the use of LDI and had the right monitoring arrangements;

TPR’s approach to DB funding has actively encouraged the widespread use of leveraged LDI by focusing on funding volatility as the primary risk that trustees must manage. This compelled schemes to structure their investments to move in line with changes to their discount rate. And given the low returns from these assets, where schemes could not meet stringent funding requirements this encouraged them to seek returns elsewhere in their asset allocation while relying on leverage in their LDI portfolio to hedge against interest rate movements.

It also underplayed other risks, including the duration risk schemes are exposed to when they adopt leveraged LDI strategies, and which proved material to schemes during the yield spike following the mini budget.

Despite its overall approach to DB funding encouraging the widespread adoption of LDI, TPR has done little to monitor its use by schemes.

Whether DB schemes had adequate governance arrangements in place. For example, did trustees sufficiently understand the risks involved?

Whether suitable governance arrangements were in place to oversee LDI strategies is a question that will require further investigation. It seems clear, however, that trustees were poorly informed by their advisers of the risks involved with LDI strategies. Anecdotally, where trustees raised concerns in the past about the suitability of LDI strategies, they report finding it impossible to push back against the strong consensus among advisers and regulators. The TUC would argue therefore that measures to further empower trustees should be explored. This would not only benefit individual schemes by giving trustees more freedom to adopt funding strategies that are appropriate, it would also reduce the systemic risk that arises when schemes are compelled to adopt similar investment strategies.

Whether LDI is still essentially ‘fit for purpose’ for use by DB schemes. Are changes needed?

Unleveraged LDI is an expensive way of funding DB benefits. Restricting schemes from investing in higher yielding assets means that higher levels of funding are needed to provide a given level of benefits. But that does not necessarily make them not ‘fit for purpose’ and these arrangements are not likely to pose a material risk to financial markets. If trustees believe the best way of meeting their schemes obligations to members if by investing in a portfolio of government and high-quality corporate debt, they should not be prevented from doing so.

But the use of leverage in LDI strategies must be seriously questioned. Concerns have been raised about the legality of these arrangements as they rely on repo operations that are classified as borrowing in many jurisdictions, which schemes are barred from doing for investment purposes. The high degree of leverage permitted has exacerbated the stress caused by the spike in gilt yields. In their current form, leveraged LDI funds are not fit for purpose, and it is appropriate to investigate regulatory changes that could make them fit for purpose, and if this proves impossible to examine ways they could be safely unwound.

Does the experience suggest other policy or governance changes needed, for example to DB funding rules?

This episode has demonstrated that the current approach to DB funding regulation has created systemic risk that could have had catastrophic effects on the gilt market without the intervention of the Bank of England. It has also failed to protect workers’ pensions by placing funding requirements on sponsoring employers that have made it increasingly difficult for schemes to remain open, while overlooking risks in LDI strategies that have resulted in a deterioration in funding levels. The focus on volatility in DB funding requirements, and the significant negative consequences for schemes if their funding levels dip – even if briefly - at the time of their valuation, force schemes to adopt investment strategies that aim to control volatility in funding levels at the expense of long-term funding adequacy. This needs to change.  Schemes should be regulated to support strategies best placed to deliver long-term funding adequacy to pay pensions as they fall due, and the current focus on funding volatility reduced.

It is necessary therefore to carry out a detailed inquiry into DB funding regulations. This inquiry should not only look at the systemic risk to wider financial markets caused by this regulation, but also consider how effective this regulation has been in promoting high quality workplace pensions. It should look at the conduct of TPR and also consider the duties placed on it as a regulator. Work under way to develop and updated DB funding framework should be put on hold until such an inquiry is able to make recommendations.

November 2022